The S&P 500 gained 2.0% in the 3rd quarter and is up 9.1% on the year. Looking at quarterly returns for the major US Indexes, it was a quiet three months for US stocks. Looking at the month by month returns - what a wild ride! From the start of the quarter, the S&P500 gained 3.3% to a new record. Over the next month, the S&P 500 plunged 9.4% as hedge funds dumped stocks to meet credit derivative related margin calls. Once the selling stopped, stocks regained their footing rallying 8.5% through quarter end. The S&P 500 is now 0.4% away from making a new record and the Dow Industrials made a new high today.
As we wrote August 13th when the situation looked the grimmest,
"A tug of war is still going on between investors who are frantically dumping stocks to raise case to cover losses in their credit strategies, and investors with cash who are eager to snap up bargains. We believe that the combination of solid earnings growth for US corporations, solid economic growth in the US and worldwide, and low inflation despite record prices in many commodities favors the bulls, so we're staying fully invested. We believe that the current correction will be in the rear view mirror by the end of September, with the S&P 500 closing out the year up 8-10%."
The S&P 500 might gain a few percent between now and year end, but for the most part events have turned out as we expected. The only surprise is finding out that firms such as Bear Stearns, Goldman Sachs and Citibank got burned pretty badly by exposure to credit derivatives based on sub-prime mortgages - we would have thought that management of these firms knew better.
Quite a few of our financial service stocks declined 15-40% on the quarter, which hurt our overall returns. However, we regard the situation as a temporary impairment of earnings and continue to hold these companies. We don't own the primary lenders in the sub-prime market such as Countrywide and American Home Mortgage, so avoided the worst of the pain.
Unnoticed in the general melee is that technology stocks, particularly telecommunications stocks, are doing quite well this year from a combination of good earnings, rising demand and limited borrowing needs.
Fed Policy
We did not expect the Federal Reserve to cut rates in September, and the 0.50% cut actually delivered exceeded all but the most optimistic forecasts. In the short term, the Fed "saved" quite a few market participants that were on the edge of getting wiped out. In the long run, the Fed may be creating more problems. Overnight rates and long term rates (10 year treasury yields, for example) are 0.5-0.8% lower now than 4 months ago. The US dollar, which had stabilized against the Euro and British Pound, has resumed its multi-year slide. Combined with rapidly appreciating commodities prices, we expect a big move up in US inflation over the next 12 months. The Fed will raise rates to combat inflation, which will cut economic growth, which will put pressure on company earnings and ultimately the stock market. Overseas growth supported US corporate earnings through the last tightening cycle; we'll monitor the situation over the next 2-3 years to see if earnings growth can be maintained.
Energy
We wrote July 1st that, with oil at $69/barrel, we had given up on our expectation of a decline to the $50's. Even though no hurricanes disrupted supply this fall, and even with demand lower following the end of the summer driving season, oil is trading near an all time high of $83/barrel. Curiously, prices of over $3/gallon for gasoline seem to have little or no impact on demand, which remains high in the US.
Housing
Unit sales are down, construction permits are down, median prices are down, the inventory of houses for sale is up and average time to sale is up across the country, with housing in Nevada, Florida and California hit pretty hard. The real estate bear market, which we anticipated for about three years, is finally here. The foreclosure rate has only just started to pick up, and will worsen through the winter. We started dabbling into the homebuilders earlier this year thinking that the bad news was already reflected in their stock prices, but the situation only continues to worsen, so we sold those stocks last month. We expect US GDP to be depressed by about 1%/year over the next three years as the housing situation works through.
2008 US Presidential Election
We wrote in July that we thought Hilary Clinton would be the next president, and nothing happened over the summer to change that opinion. We're starting to review our healthcare stocks in that light and also thinking about the current tax regime, which is due to expire in 2010 and would likely not be renewed in a Clinton presidency. The capital gains rate, currently at 15%, would rise to its previous level of 20% and the tax rate on stock dividends, currently also 15%, would be taxed as ordinary income. We would expect investors to realize capital gains between now and 2010, especially after 2008, not only in stocks but in real estate and other assets as well. These tax sales will depress asset prices.
Strategy
We took limited tax losses in September and also have proceeds from several cash mergers in our clients' accounts. As a result, we have some cash on hand and will be investing it through October. There are quite a few bargains among financial service stocks and good opportunities in other sectors. We will be cautious however as reverberations from the credit crisis will negatively impact economic growth for at least several quarters.
Yours sincerely,
David Edwards
President